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I've finally worked my way through the final OECD BEPS reports
released in early October. Very interesting reading and an added bonus was the
good cardio exercise of carrying around the 1500 pages for several weeks while
finding travel time to slog through them all. Lots of interesting stuff in each
of the reports. The overall scope and
sheer ambition of the OECD is impressive but, as I've observed before, I think
the OECD was too ambitious and that by trying to achieve too much the ultimate
achievement will be less than it could have been. But maybe that's a good
thing.

The focus of this commentary is on the final report on Action 2 –
Neutralising the Effects of Hybrid Mismatch Arrangements. This is an incredibly
complex area. I expressed my skepticism about the likelihood of producing
workable rules in this area in a prior commentary where I observed, "Given
the multitude of reasons why there could be a potential mismatch resulting in a
tax benefit to the `borrower' that is greater than the tax cost to the
`lender,' it is hard to see the best way to construct an anti-avoidance
principle to limit such result… ."2
I still stand by that view, but what I hadn't realized at that time was the appetite
for complexity on the part of the OECD in facing the challenge of dealing with
the multitude of possible or perceived mismatch situations.

So the comprehensive report on hybrids bravely attempts to deal with
all manner of potential mismatches that one could imagine – even a few I had
not imagined. The report exceeds 450 pages (single-spaced and dense). It
contains 80 examples of particular hybrids and how they should be dealt with,
which make up 285 of the 450+ pages. It includes 12 areas of recommendation,
all of which are multi-faceted. The recommendations for the most part require
legislative action by each country and the intent is that countries all follow
a consistent design to ensure achievement of the goal of eliminating the
targeted hybrid mismatches. I view the odds of consistent adoption of the
numbingly complex recommendations to be near zero, but the chances of selective
adoption of any attractive revenue-generating aspects of the report to be high.
With the result being greater likelihood of companies facing disallowances,
controversy, and double tax.

Recommendation 9 includes the design principles for the report. (I
might have thought design principles would come earlier than ninth?) To quote:

The hybrid mismatch rules have been designed to maximize the
following outcomes:

(a) Neutralise the mismatch rather than reverse the tax
benefit that arises under the laws of the jurisdiction;

(b) Be comprehensive;

(c) Apply automatically;

(d) Avoid double taxation through rule coordination;

(e) Minimize the disruption to existing domestic law;

(f) Be clear and transparent in their operation;

(g) Provide sufficient flexibility for the rule to be
incorporated into the laws of each jurisdiction;

(h) Be workable for taxpayers and keep compliance costs to a
minimum; and

(i) Minimize the administrative burden on tax authorities;
plus

(j) Cure all disease, end poverty, and eradicate world
hunger.

Okay, I added on the last one. But even if well-intentioned, the
goals are perhaps a bit too lofty and unrealistic to be achievable. I think
that's largely borne out when one considers the details. I'll make some
comments on the recommendations I find most interesting, which include those on
hybrid financial instruments (recommendations 1 and 2), disregarded hybrid
payments (recommendation 3), reverse hybrids (recommendations 4 and 5), dual
resident payers (recommendation 7), and imported mismatches (recommendation 8).

Starting with hybrid financial instruments – although more complex
in its definition, think of a related-party instrument treated as debt in the
borrower country but equity in the lender country and the lender country
providing beneficial treatment to the dividend recipient in the form of
exemption or potentially underlying foreign tax credit relief. The report
considers this a deduction/no inclusion (DNI) result (despite the fact that it
may really be a deduction combined with an inclusion with credit or a partial
rather than full exemption). The report provides for a primary and a secondary
response for dealing with this DNI outcome (as had the interim report for
Action 2). The primary rule proposed in recommendation 1 is that the payer
jurisdiction should deny a tax deduction for what it sees as an interest
payment to the extent of the DNI outcome.
If the payer jurisdiction does not act to deny the deduction, the
secondary rule is for the payee jurisdiction to fully include the payment in
income – without underlying credit benefit. Interestingly, recommendation 2,
which contains a broad rule for adoption in a country's domestic law, calls for
a denial of dividend exemption or a denial of the granting of underlying
foreign tax credits for dividends that are deductible in the payer country.
This rule would obviously result in the secondary rule becoming the rule and
the payer country no longer having a basis to deny a deduction – which seems
excessively confusing. So if I try to follow the OECD's path, it's a three-step
analysis: First, all countries should act to deny exemption or credit relief
for a hybrid dividend. Second, if such a general rule is not adopted by a
particular payee country or if it is not applicable to a particular instrument,
the payer country of a hybrid mismatch payment should deny the deduction.
Third, if there is no such denial by the payer country, the payee country of
that hybrid mismatch should fully tax the payment, which would mean denying
exemption or credit relief for the payment. Sounds like a bit of a circle,
doesn't it?

The recommendations specify that the denial of deduction should be
aligned with the extent of the non-taxation of the payee. So if, say, a 90%
exemption, then a 90% disallowance. And
in situations where the benefit is in the form of a foreign tax credit, there
would be a need to compute the extent to which the credit led to a non-tax
result. This latter situation seems particularly messy since a disallowance by
the payer country would increase the underlying tax on the payer. This would
potentially result in a circular calculation. Moreover, the deemed paid credits
used to offset the hybrid payment would almost certainly result in there being
fewer credits left to offset the payee country tax on future dividends. Thus, a disallowance likely would result in
current or eventual double taxation. The report in example 1.4 glosses over
this issue. Apparently, potential double tax doesn't merit the same in-depth
thinking as does double non-tax.

Differences in timing of deductions versus inclusions are also
covered in recommendation 1. This could have an impact on discount notes or
similar instruments. The recommendation excludes a timing difference from being
considered a hybrid mismatch where the payment will be included as ordinary
income "within a reasonable period of time." The report specifies a
safe harbor of 12 months as reasonable. Not really long enough to be very
comforting when faced with the prospect of a permanent disallowance – again, a
double tax risk that is not addressed. To the extent this approach is
implemented by countries, there could be some practical issues for
multinationals.

Recommendation 3 deals with disregarded payments made by a
disregarded entity. So a fact pattern which could exist would be a U.S.
multinational (P) that owns a first-tier foreign subsidiary (S1) that is
checked as disregarded and that owns a second-tier subsidiary (S2) in the same
country that is regarded and that is eligible for consolidation or group relief
in such country. In the case of a loan from P to S1, deductible interest
payments could be made by S1 to P which could reduce local tax in S2 under the
Country S consolidation/group relief rules. The primary rule proposed by
recommendation 3 would be for Country S to disallow the disregarded payment and
the secondary rule would be for Country P to tax the disregarded payment. The
rule would apply to all disregarded payments, not just interest, but, for
example, rents, royalties, and service payments as well, to the extent that the
deductible payment exceeds the so-called dual inclusion income that is
recognized as taxable income in both countries. Sounds a lot like our U.S. dual
consolidated loss rules, with the added twist of a recommended secondary rule
that would override the effect of our U.S. check-the-box rules. Determining
which country should act and to what extent would involve a complex interaction
of the tax laws in Countries P and S due to the potential for differences in
the computation of taxable income and expense items. The simple and clear
approach taken in our U.S. dual consolidated loss rules (I'm kidding) would
likely be a starting point, but with the need also to coordinate potentially
dueling dual-consolidated-loss-like rules in the parent and subsidiary
countries. Interestingly, recommendation 3 is the shortest of the 12
recommendations and only two specific examples are provided. Perhaps the OECD
drafters have not fully considered the potential complexities or perhaps they
are disinclined to go into as much detail in this area to ensure a workable
rule because they feel that those who check-the-box do so at their own peril,
which would seem to be blatantly targeting U.S. multinational
corporations. Moreover, it seems to me
that this rule would have lots of potential implications for branches and
permanent establishments as well, which, if the Action 7 recommendations are
implemented, will be a lot more prevalent in the future.

Recommendations 4 and 5 deal with reverse hybrids. In the U.S. context, think of a foreign
entity treated as transparent locally (say, as a partnership) but as a
corporation in the owner's country. U.S. LLCs owned by non-U.S. investors would
seem also to be a typical example of a reverse hybrid. The report considers a
payment to a reverse hybrid to create a hybrid mismatch to the extent there is
a deductible payment made to the reverse hybrid and the related income is not
taxable to the owner of the reverse hybrid. The rule recommended by the report
is that the payer country should disallow deductions for the payments to the
extent the income is not taxed to the reverse hybrid owner. As with the
proposed disregarded payment rule, this would not apply only to interest
payments, but presumably could apply also to rents, royalties, service
payments, etc. Note that there is no secondary rule proposed in this case,
although recommendation 5 does encourage jurisdictions to improve their CFC
regimes in order to prevent this type of DNI outcome. The report makes clear in
an example that, to the extent the income of a reverse hybrid is fully taxed
under a CFC regime, the payer country should not treat the payment as a hybrid
mismatch — with the burden of proving full current taxation falling on the
taxpayer. In this regard, however, the inclusion of the reverse hybrid income
in the investor country through a dividend payout rather than a CFC inclusion
would not be satisfactory from the OECD's standpoint to trigger a turning off
of the treatment of the arrangement as a hybrid mismatch.

The other design proposal in recommendation 5 is for countries to
limit the tax transparency of an entity to the extent it is owned by foreign
investors. So presumably they would propose that U.S. LLCs be taxed as
corporations to the extent they are owned by non-U.S. persons. A pretty
dramatic proposal for change. And one
that feels more than a little discriminatory.

The dual resident proposals of recommendation 7 are aligned in
concept with the disregarded payment proposals of recommendation 3 and again
would have some similarity to our U.S. dual consolidated loss rules. But the
rule proposed is for both countries in which a company is tax resident to
disallow a deduction for a payment that could result in a double tax deduction,
so there is no ordering rule as in the recommendations that use a primary and
secondary rule approach. The report acknowledges that simultaneous application
of the rule has the potential to create double taxation. But this potential
outcome is dismissed since "structuring opportunities will usually be
available to avoid the risk of double taxation." I don't feel particularly
comforted by this. Perhaps they should at least admonish countries not to
invoke their GAARs when a company is doing such a restructuring to avoid the
double taxation that otherwise would arise. Maybe I am being paranoid, but the
times seem to call for a little paranoia.

My "favorite" recommendation is number 8, the imported
mismatch rule. This rule applies any time there is a deductible payment to a
payee that benefits from a hybrid mismatch to reduce the payee's tax on the
deductible payment. The rule can apply through unlimited tiers of related
entities which would seem likely to cause incredible potential complexity and I
could foresee enormous taxpayer burden in having to disprove the existence of
any tainted imported mismatch anywhere in the chain of intercompany treasury
transactions.

I think it's best to use one of the examples in the report to
illustrate the potential scope of this rule. Example 8.7 seems a good (or
perhaps bad is the right word) one to focus on.
The facts are illustrated as follows:

[Image]So definitionally there
is an imported mismatch involved here because C Co has made a hybrid payment to
A Co – one might think in terms of a Luxembourg company with preferred equity
certificates or PECs. The non-hybrid interest payments (direct or indirect)
made by the other companies in the A Co group are all subject to potential
disallowance, but only up to the amount of the hybrid mismatch payment. So which country gets to disallow the
interest payment made by its local subsidiary? The proposal would focus on the
country with the imported mismatch that is most direct, to the extent that
country adopts the imported mismatch rule. The example assumes that Countries
D, E, and F all adopt the imported mismatch rule and that the other Countries
C, B, G, and H do not. In that case, Country D gets to disallow the full 200
interest payment to C Co, which matches the amount of the hybrid payment by C
Co. Countries E and F would not get to disallow any interest payment because
the hybrid mismatch has been neutralized by a disallowance to a less indirect
borrower. If Country D did not implement the recommendation, Countries E and F
could disallow the full 100 interest payment in each country, unless Countries
G and H also implemented the recommendation, in which case they could each
disallow a proportionate amount of their payments – in that case, since in
total 400 of deductible payments would be implicated with only a 200 hybrid
mismatch, each country could disallow 50 of the 100 interest payment.

Don't forget a hybrid mismatch for this purpose could arise from a
hybrid instrument, a disregarded payment, a reverse hybrid or a dual resident
company payment. The level of transparency, knowledge of foreign country rules,
burden of proof, and implications of currency differences and valuation
differences that would be involved are just a few quick reasons why this
proposal seems totally unworkable.
Drafting legislation and regulatory guidance to enact such a rule would
seem nigh on impossible, much less actually administering it in practice. But
take heart — "structuring opportunities will usually be available to avoid
the risk of double taxation." That's starting to seem like a common theme
– let's propose rules that are so unmanageable that hybrids can no longer
exist. However, that unreasonable
starting point presumes that hybrids are all optional and since we live in a
world of disparate national rules, hybridity — good and bad, however you define
what's good and what's bad — is a reality that can be unavoidable.

Just think for a moment about what statutory changes would be needed
in the United States if the OECD recommendations were ever to be adopted. It
seems to me that changes would be needed to §385, the foreign tax credit rules,
§7701 with respect to LLCs and conduit financing, the check-the-box rules, the
dual consolidated loss rules, and probably the withholding tax rules, as a
start. Needless to say, I find it all hopelessly impractical and can't help
thinking our well-intentioned colleagues at the OECD may have gotten carried
away.

There are a few good (at least in relative terms) aspects of the
report. It acknowledges that differences in statutory tax rates alone do not
create hybrids – so even loans from a tax haven entity would not be affected by
Action 2. Notional interest regimes that grant deemed deductions on all equity
would not be affected because they are seen as an effective lowering of a
country's statutory rate. Interest-free loans where a deemed deduction is
granted in the borrowing country similarly would not be implicated. Of course,
I would never have imagined that any of these structures could be considered
hybrids, but after seeing how far the OECD was willing to go, it's nice to see
confirmation of these points in the report.

Fortunately, all the recommendations in this report require local
country action to take effect. Let's hope countries all think this through
before blindly jumping on the BEPS bandwagon in respect to hybrids. But as I am
writing to conclude this commentary, this hope is quickly fading as I have just
read proposed U.K. legislation on "hybrid and other mismatches" which
runs 48 pages and essentially proposes to wholesale adopt the unwieldy OECD
recommendations, effective as of January 1, 2017. Naturally with
"only" 48 pages rather than over 450 pages and without the benefit of
the numerous OECD examples, there no doubt will be disconnects from the OECD
construct. So there is a high risk of double tax occurring when other countries
start adopting their own versions. And as this goes to press, even more
disturbing is the proposal for an EU directive on BEPS generally which seems to
attempt to put forth a principles-based, anti-hybrid approach that is very hard
to understand but that one can be sure will create lots of problems if adopted.

The bottom line seems to be that 2016 should be a year of
restructuring group treasury arrangements in order to avoid double tax risks
and extended controversy.

This commentary also appears in the February 2016 issue of the Tax Management International Journal. For
more information, in the Tax Management Portfolios, see Daher, 536 T.M.,
Interest Expense Deductions, Maruca and Warner, 886 T.M., Transfer
Pricing: The Code, the Regulations, and
Selected Case Law, and in Tax Practice Series, see ¶2330, Interest Expense,
¶3600, Section 482 — Allocations of Income and Deductions Between Related
Taxpayers.

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